Despite US equities trading into “correction” territory, on an intraday basis on Friday, all three major indices turned higher and managed to close well above their respective 200 DMAs.

Friday’s reversal higher and positive close was accompanied by a massive surge in volume on both the NYSE (7.05%) and Nasdaq (+17.35%).

Double-digit declines don’t usually mean a loss for the year.

US crude records its largest weekly drop in two years.

US crude production to jump above 11 million barrels/day by November, 2018 – EIA

Here’s a little perspective for these times of market turmoil. Since November 1, 2016, and including the sell-off that rocked markets this week:

S&P 500 (^GSPC, SPY) has risen 421 points or 19.1% and closed on Friday 8% below its record high close of 2872.87.

Dow Industrials (^DJI, DIA) have risen 5,067 points or 26.4% and closed on Friday 9% below its record high close of 26,616.71.

Nasdaq Composite (^IXIC, QQQ) has gained 1,551 points or 29.1% and closed on Friday 8% below its record high close of 7505.22.

The underlying economic and corporate earnings fundamentals are sound

US equity markets have posted significant 52-week gains due largely to an expanding economy, near full-employment, an accelerating GDP, improving corporate results and near record-high levels of consumer and small business confidence. US corporate results, in the form of the S&P 500, are beating estimates at the best rate since 2009 this earnings season. And though all of those themes have remained constructive data points for investors there have been several themes that have dramatically triggered a long-dormant risk-off appetite on the part of investors.

The weakness exhibited by US equity markets at the outset of February set the stage for a pullback. A sudden break in the advance/decline metrics, coupled with the first hints of price instability exhibited at the start of the month, shifted the market outlook from confirmed uptrend to uptrend under pressure. Following that technical reframing, economic data and several earnings reports provided the context for a more meaningful pullback.

The most glaringly obvious of those themes is monetary policy. There is no question that given the wage growth data that was highlighted in the last monthly employment report (January’s) inflation is making its way back into the economic landscape. As per the report, annualized wage growth at 2.9% is above the rate we have seen in the report since the financial crisis. However, that wage growth, though welcome, is still not as disruptive as markets are pricing in. The fear is that the Fed will take a more aggressive posture on tightening in the event we see an uptick in broader measures of inflation. We should get a degree of clarity on that this week with the release of the Atlanta Fed Business Inflation Expectations report, the PPI-FD, and the Import-Export Prices release.

Rising rates, as a result of monetary tightening, change the equation for investors. Not only does it spell the end to the long-running bull market in bonds (which we have covered in previous notes) it also reintroduces a degree of competition for equities. Additionally, it officially will mark the end of cheap money. Cheap money has played an enormously significant role in reflating the economy in the post-financial crisis world. It has been a monetary policy tool used not only by the Federal Reserve, but also by every central bank in the world. Tightening by the US Fed speaks to increased capital costs for consumers, businesses, and very importantly, the United States government. Given the doubling of the deficit over the past eight years to more than 20 trillion dollars, the rising cost of capital could potentially spell real trouble for the US economy in the not too distant future.

Another headwind, though likely more temporary for US equities, has come from the energy sector. Earnings disappointments from ExxonMobil and Chevron have set the stage for sector weakness. As we have discussed in detail here in the note, US crude production, in the form of shale oil, has ramped up dramatically with the advent of rising energy prices globally. We have OPEC to thank for that because OPEC production restrictions have effectively raised crude prices. Those rising prices have brought back into play US production. The IEA, for example, expects US production to top 11 million bbl/day by November of this year. It was only last November that US production eclipsed 10 million/bbl day. That surge in production, coupled with broader anxiety being priced in nearly all asset classes, fueled the worst retreat in crude prices since 2016. On February 1, crude closed at $65.80/bbl. Friday it closed at $59.20/bbl. In a matter of little more than a week, WTI crude lost 10%.

Photographer: Krisztian Bocsi/Bloomberg

Another sector of the market that provided additional momentum to the trade lower came from large-cap tech. Apple released weak guidance and weaker-than-expected handset sales figures for the period, setting off a slide in the name as well as in the entire supply chain ecosystem.

In short, last week leadership to the downside came from the energy and large-cap tech sectors while the broader underpinning for the slide in equity prices came from the fear of tightening monetary policy. That fear was most easily evidenced by the rapid rise in rates with the 10-year getting most of the attention. Volatility exploded as fear set in, and the long-awaited pullback took shape.

The good news is that all three major US equity indices closed out the day on Friday on a decidedly positive note and did so on expanding volume. The S&P 500 rebounded sharply from its 200 DMA on Friday, and with that, the volatility Index receded.

The wild ride isn’t over, though market volatility will likely subside and prices should begin to stabilize this week

The type of move to the downside to which we have been treated to over the past two weeks doesn’t simply stop on a dime. It will take time for investors to recalibrate risk/reward. Equities will no longer be trading in a vacuum. In fact, monetary policy and interest rates will now play a more historically rooted role in the allocation of risk. That means that equity selection will become more strategic. As I indicated in my annual “Year Ahead” note at the end of December, this year will be a more challenging year for investors. Rising interest rates as a result of eventual above-target inflation, tightening labor markets and several other themes will play a hand in making the investing landscape less myopic and as a result more challenging.

This week’s economic calendar will provide investors with some data with which to gauge the trend-line for inflation, as well as the health of the overall economy. With a focus on inflation, the CPI reading for January is released on Wednesday. Bloomberg consensus is calling for a M/M reading of 0.3% versus December’s 0.1%. The Y/Y reading is expected to come in at 2.0%. Less food and energy, the M/M is expected to come in at 0.2%, and the Y/Y is expected to be 1.7%. It is important to note that if Bloomberg consensus is accurate, these readings will not reflect a meaningful uptick in inflation. The Atlanta Fed Business Inflation Expectations report for February is released on Wednesday at 10:00 a.m. EST. Last month, the Y/Y reading came in at 2.0%. Again, not an alarming data point and should not trigger a meaningful uptick in investor concern—as long as it is in-line with the previous month.

Investors will be keeping a very close eye on the EIA Petroleum Status Report on Wednesday as well. As we have discussed at length here in the note, US production has been ramping up dramatically in recent months. As a result, we are finally beginning to see a build in inventories. For the week ending February, crude, gasoline and distillates inventories all rose—1.9M bbl, 3.4M bbl, and 3.9M bbl respectively. Those builds, coupled with expanding US production, are helping to contain WTI crude pricing in an expanding domestic and global economy.

On Thursday we receive the Producer Price Index – Final Demand (PPI-FD) reading for January. Bloomberg consensus is calling for a M/M reading of 0.4%. December’s reading was -0.1%. The Y/Y reading for December was 2.6%. A reading at or below 0.4% would help tame volatility to a degree. Weekly jobless claims, out Thursday, will very likely provide further evidence of additional tightening in the employment market. Bloomberg consensus is calling for the weekly total of claims to be 229k for the week ending February 10. The prior weekly reading was 221k. On January 29, the 10-week average fell to a 45-year low. Though this a great news for American workers and does speak to a healthy job market, investors have shifted the focus from a healthy job market to the prospects of inflationary pressure as a result of labor force tightening.

On Friday, Import and Export Price data is released for January. Bloomberg consensus is calling for an import price M/M reading of 0.6%. The export M/M is expected to be 0.3%. The last data release of the week, the Baker-Hughes Rig Count, will likely reflect another rise in total rigs for North America. Last week’s reading was 1,300, up from 1,288 the previous week.

Investors head into the week a bit shell-shocked after a week that saw the Dow Industrials move an aggregate of close to 20,000 points in both directions. Friday’s reversal certainly helped investor psychology, in that most were expecting a washout trade heading into the weekend. Friday’s reversal was significant. It provided for a lift to index prices that saw indices close above a 10% correction. Additionally, it came on Friday—allowing for a break in the global trade and an opportunity for a reset. The welcome reversal on Friday was led by financials, health care, technology, telecoms and utilities.

Commentary by Sam Stovall, chief investment strategist at CFRA Research

Despite Friday’s reflex rally, this decline may resume and conclude with a double-digit correction, rather than the sub-10% pullback already recorded on a closing basis, due to how far the S&P 500 traded above its 200-day moving average and how elevated prices had become relative to EPS and inflation. A silver lining in all of this is that sharp and swift sell-offs have traditionally led to quick conclusions and rapid recoveries. In addition, following the end of corrections and bear markets, the three sectors and 10 sub-industries that were beaten up the most typically became the new leaders. Even though the worst might not be over, we are not projecting the start of a new bear market, since we don’t forecast recession. This year we see Real GDP rising 3.1% and S&P 500 EPS up more than 19%, combined with a 2.90% 10-year yield and a 1.9% y/y change in Core CPI by the final quarter of 2018.